Self Directed IRA Lawyers

The "Rollover Business Start-Up" (ROBS) Solution

The Business Acquisition & Compliance Solution Structure (BACSS), also known as the “Rollover Business Start-Up” (“ROBS”) Solution, is an IRS and ERISA approved structure that allows an individual to use retirement funds, such as an IRA or 401(k), to purchase a new or existing business or franchise tax-free and penalty-free. The ROBS arrangement typically involves rolling over a prior IRA or 401(k) plan account into a newly established 401(k) plan, which a start-up C Corporation business sponsored, and then investing the rollover funds in the stock of the new C Corporation.

The concept of using a 401(k) plan to purchase employer stock has been included in the Internal Revenue Code for over 30 years and is based on the notion that allowing employees to use their 401(k) plan funds to purchase stock of the company they work was a positive benefit that would help the employee benefit from the increase in value of the employer. This is the reason that this benefit only applied to 401(k) plans and not to IRAs. The purchase of employer stock is called qualifying employer securities and the majority of the Fortune 500 companies allow their employees to use their 401(k) plan funds to buy stock in the company they work for.

Over the last 15 years or so, many attorneys have taken the concept of using a 401(k) plan to buy stock in the employer to start-up companies. The idea was that if this strategy could work for public companies, such as IBM and GE, why couldn’t it work for a new business looking to buy a franchise or an existing business seeking additional funds. As long as the company was a C Corporation and 401(k) plan funds were being used to buy the stock, the same rules should apply which allow for suck stock transactions to occur.

Due to the 2008 financial crisis, the ROBS solution has become a very popular method for sing retirement funds to start a business tax-free and penalty-free. The ROBS solution is generally the only way one can use more than $50,000 of retirement funds to invest in a new or existing business that you or any disqualified person will be directly involved in on a day-to-day basis and earn a salary as an employee of the business.

IRS Response

The October 1, 2008 Memorandum

On October 1, 2008, Michael Julianelle, Director, Employee Plans, signed a “Memorandum” approving IRS ROBS Examination Guidelines. The IRS stated that while this type of structure is legal and not considered an abusive tax avoidance transaction, the execution of these types of transactions, in many cases, have not been found to be in full compliance with IRS and ERISA rules and procedures. In the “Memorandum”, the IRS highlighted two compliance areas that they felt were not being adequately followed by the promoters implementing the structure during this time period.

The first non-compliance area of concern the IRS highlighted in the “Memorandum” was the lack of disclosure of the adopted 401(k) Plan to the company’s employees. The IRS believed that in too many instances the promoter was establishing a 401(k) Plan that was not adequately disclosed to all employees. Internal Revenue Code Section 401(a)(4) provides that under a qualified retirement plan, contributions or benefits provided under the plan must not discriminate in favor of highly compensated employees. In addition, the promoters were encouraging the business owner who had used their retirement funds to purchase company stock to not provide the same benefit to their employees.

The second non-compliance area of concern the IRS highlighted in the “Memorandum” was establishing an independent appraisal to determine the fair market value of the business being purchased.

The August 27, 2010 IRS Public Phone Forum

On August 27, 2010, almost two years after publishing the “Memorandum”, the IRS held a public phone forum open to the public which covered transactions involving using retirement funds to purchase a business. Monika Templeman, Director of Employee Plans Examinations and Colleen Patton, Area Manager of Employee Plans Examinations for the Pacific Coast spent considerable time discussing the IRS’s position on this subject. Monika Templeman began the presentation reaffirming the IRS’s position that a transaction involving the use of retirement funds to purchase a new business is legal and not an abusive tax-avoidance transaction as long as the transaction complies with IRS and ERISA rules and procedures. The concern the IRS has had with these types of transactions is that the promoters who have been offering these transactions have not had the expertise to develop structures that are fully compliant with IRS and ERISA rules and regulations. The IRS added that a large percentage of the transactions they reviewed were in non-compliance largely due to the following non-compliance issues: (i) failure by the promoters to develop a structure that requires the new company to disclose the new 401(k) Plan to the company’s employees and, (ii) the failure to require the client to secure an independent appraisal to determine the fair market value of the company stock being purchased by the 401(k) Plan. The IRS concluded by stating that a transaction using retirement funds to acquire a business is legal and not prohibited so long as the transaction is structured correctly to comply with IRS and ERISA rules and procedures.

Legal Foundation for the ROBS Solution

An individual retirement account investor is able to use retirement funds to invest in an active trade or business with tax or penalty because the ROBS solution qualifies for a special exemption set forth under IRC 4975(d) to certain prohibited transaction rules. The exemption to the prohibited transaction rules under IRC 4975(d) is centered around ERISA Section 408(e). It is IRC Section 4975(d) and ERISA Section 408(e) which shields employers from scrutiny of routine (non-abusive) corporate transactions by the plan sponsor and other “disqualified persons,” which might otherwise constitute technical violations of the prohibited transaction rules (due to the employer-sponsored retirement plan’s ownership of employer securities). If the plan sponsor and other fiduciaries’ routine corporate transactions did not fall within the purview of ERISA Section 408(e), the prohibited transaction rules would needlessly prohibit a myriad of legitimate business transactions and would ultimately nullify the exemption that Congress intended to provide. To accomplish its intended effect, ERISA Section 408(e) must be read to exempt the natural and necessary commercial consequences of owning corporate stock, rather than just the stock purchase or divestiture.

Internal Revenue Code Section 4975(c) includes a list of transactions that the IRS deems “prohibited”. However, Internal Revenue Code Section 4975(d) lists a number of exemptions to the prohibited transaction rules. Specifically Internal Revenue Code Section 4975(d)(13) lists an exemption for any transaction which is exempt from section 406 of the Employee Retirement Income Security Act of 1974 (ERISA) by reason of section 408(e) of such Act.

Section 408(e) provides that section 406 shall not apply to the acquisition or sale by a plan of qualifying employer securities (as defined in section 407(d)(5), provided that: (1) the acquisition or sale is for adequate consideration; (2) no commission is charged with respect to the acquisition or sale; and (3) the plan is an eligible individual account plan (as defined in section 407(d)(3)). A 401(k) plan fits in to this definition.

Outside the context of ROBS arrangements, many 401(k) plans permit participants to invest in employer stock. A number of large 401(k) plans, including plans sponsored by Apple and Pepsi, include substantial allocations of employer stock.

How Does the ROBS solution differ than a Self-Directed IRA LLC or Solo 401(k) Plan?

At first glance, using a Self-Directed IRA LLC or Solo 401(k) to purchase stock in a corporation would seem to share many similarities with the ROBS structure. Unfortunately, with a self-directed IRA LLC or Solo 401(k) plan you would generally not be able to invest in a business that you or any disqualified person would have any direct or indirect ownership in without triggering a prohibited transaction under IRC 4975. Only the ROBS solution, which involves the purchase of qualifying employer securities by a 401(k) plan, satisfies an exemption under the prohibited transaction rules as per IRC 4975(d).

The recent U.S. Tax Court case Peek v. Commissioner, 140 T.C. No. 12 (May 9, 2013), highlights the risk and limitations involved when using a Self-Directed IRA to purchase business assets. In the Peek case, the taxpayers used IRA funds to invest in a corporation that ultimately purchased business assets. Because Mr. Peek used an IRA and not a 401(k) Plan to purchase the C Corporation stock, Mr. Peek was not able to earn a salary or personally guarantee a business loan, which ultimately was the cause of the IRS prohibited transaction rule violation.

If Mr. Peek had used a ROBS strategy to buy the corporation stock, he would have been able to purchase business assets with retirement funds, earn a salary from the business, as well as personally guarantee the business loan without triggering the IRS prohibited transaction rules.

To learn more about how you can use retirement funds to buy a new business or finance an existing business, please contact us at 800-472-0467.

Did you know? Anyone can serve as trustee of the Solo 401(k) Plan.